Washington Square Capital Management Blog

We hope all of you in the north-east made it through Hurricane Sandy safe and sound. For many of us, it was a reminder of the awesome power of mother nature, the interconnectedness of our modern lives and the fragility of our beautiful planet. US stock markets were closed for two days straight, and our offices in lower Manhattan will be without power till the weekend. We have been working remotely, and it has been a good test of our disaster readiness procedures.

The big economic news of the third quarter was the Federal Reserve’s decision to take the unprecedented step of intervening in the capital markets during the home stretch of a presidential election campaign. We’ve noted in previous letters that as a non-partisan institution, the Federal Reserve prefers to avoid any appearance of political favoritism, often going to great lengths to maintain this reputation. By intervening in the capital markets at the height of election season, the Fed risks the appearance of favoritism towards the incumbent party. Expansionary monetary intervention can drive stock market rallies and boosts investor confidence, benefiting the party in power – in this case, the Obama administration. Using this logic, our thinking was the Fed would abstain from announcing any new stimulus plans until after the election. It turns out we were wrong.

On Thursday September 13th, by a vote of 11-1, the Federal Reserve board voted to launch QE3, their latest and greatest stimulus plan effort. Unlike past plans, this one is unique in that it is open-ended, there isn’t a set expiration date or monetary cap. And instead of purchasing US Treasuries, which the Fed has done in the past, QE3 involves a $40 billion monthly purchase program of agency mortgage-backed securities. In addition to QE3, the Fed also announced that it expects to keep interest rates close to 0% through the end of 2015 (having previously stated that rates would remain at this level through 2014).

These policy announcements come on the heels of the Fed’s June 20th decision to extend Operation Twist through the end of 2012 and the European Central Bank’s Sept 6th decision to initiate their own open-ended “no limit” bond buying program to purchase European sovereign debt as and when needed. Four years after Lehman Brothers’ failure, the Fed and ECB continue to reload their monetary “bazookas”.
So why is the Fed stepping in now with such a bold plan given the upcoming election and their recent action in June? Well, with a muddled employment picture and a relatively stagnant housing market, the Fed sees monetary stimulus as a necessary crutch to keep the economic recovery moving forward, especially since the current Congress has no interest in passing any further economic stimulus. By purchasing these bonds, the Fed hopes to lower rates and encourage companies to borrow and expand operations (hire more people), and nudge individuals to buy large ticket items (spend more money) and take on mortgages (buy homes).

Sounds good, right? What could be wrong with encouraging corporate hiring and consumer spending? Well, several things, actually:

1. Inflation: If the economy recovers sooner than expected, food, materials and energy costs may rise much faster than the economy.
2. Weak dollar: A weaker currency makes imports more expensive and can drive inflation further. The flip side of this is that a weaker dollar makes US exports more competitive.
3. Encourages speculation: Low interest rates imply cheap credit, so speculative investors – the kind whose actions led to the credit crisis — can afford to take on more risk through leverage and loans. And as high-risk assets outperform, these speculators are financially rewarded.
4. Punishes savers: Conservative investors – the ones who were fiscally responsible during the housing mess – are punished. These investors (often retirees) who normally keep their money parked in savings accounts, short term CDs or Treasuries are being forced into riskier asset classes because interest rates are so paltry. More money heading into riskier or longer-dated bonds drives those rates even lower, so savers have to be even more aggressive than ever to generate decent returns.
5. Using all their bullets: Now that the Fed has given the market what it wants – a virtually unlimited supply of stimulus, QE to infinity – how will they ever top this? If things turn south in the global economy, what can the Fed do to calm nervous investors?
6. Sets the housing market up for a fall: Real-Estate prices are extremely sensitive to interest rates since most buyers borrow some portion of the purchase price of their home. Higher interest rates lead to higher monthly payments, which in turn drives home prices down. At the moment, low rates are propping up home prices, when they begin to rise, this support will disappear and home prices may well stagnate or fall.

We also see the election and the forthcoming budgetary debate having an impact on municipal bonds and US state finances. Over the next few months, one of the major ratings agencies will revise the way it accounts for the long-term pension liabilities incurred by municipalities. Many state budgets and finances are still in a weak state after the crisis, and this revision may lead to some ratings downgrades. In addition, we expect the US federal deficit to take center stage after the election. Regardless of which party controls congress or the presidency, we expect to see federal support to states weaken further. This means states will have to fend for themselves, implying weaker municipal credits, absent a very strong recovery.

So how should investors respond to these new policies? We prefer a conservative balanced portfolio of stocks and bonds for most investors. We are reluctant holders of interest-rate sensitive or cyclical stocks and longer-term bonds, recognizing that the Fed’s policies are driving prices up in those sectors. We retain a preference for high quality, dividend-paying stocks and utilities. In the bond market we continue to limit holdings to high-quality corporate, municipal and international emerging market debt, keeping maturities short. We realize this is not a recipe for outsized returns, but we would rather be safe than sorry.

As we approach the holiday season, we recommend all clients consider the following year-end planning items:

• Review your 401K contributions (you have until Dec 31 to use the 2012 limits), and IRA contributions.
• Consider re-allocating between securities as the Bush tax cuts sunset and capital gains rates may go up.
• For those with taxable estates, it is worth reviewing the special gifting opportunities available in 2012.

As most of these items involve tax-planning, and since we do not provide tax-advice, we do recommend consulting you tax professional prior to taking any action. We are, as always, happy to assist.

We hope you’re enjoying your summer and are staying cool.

In our previous letter, we noted that the gaudy first quarter returns for risk assets (namely US stocks) were on an unsustainable trajectory and unlikely to continue upwards indefinitely. As we anticipated, the second quarter saw a steep selloff in risk assets as problems in Europe continued to deteriorate and US economic data disappointed. In June, equity markets rallied back a bit on the news that the Federal Reserve will be extending its Operation Twist policy through the end of 2012. However, this commitment fell short of what many risk investors were hoping to see in response to a global slowdown. As a result, risk assets have begun to sell off again as we enter the third quarter. So long as central banks continue to intervene in the financial markets (and investors anticipate these moves), we expect equity and bond markets will continue to respond in volatile fashion.

From a valuation standpoint, we believe US stocks appear to be near cyclical highs. The S&P 500 currently trades at a Price-Earnings (P/E) ratio above 16, which is above the historical average. The cyclically adjusted P/E ratio or CAPE, (a longer-term measure that averages 10 years of earnings) is at an even greater extreme of 22. Over the past century, US stocks have reached cyclical peaks with a CAPE over 22 on five occasions, in 1929 (at 32.5), in 1966 (at 24.1), in 2000 (at 44.2), in 2007 (at 27.5) and in 2011 (at 23.48).  While stock prices could certainly continue to march higher, we don’t view these valuations as a bargain.

In our view, Europe continues to be the main driver of movements in most major markets, including bonds and foreign-exchange. The Euro has weakened substantially against most major currencies as it becomes clear that European institutions have no conclusive solution to the peripheral crisis (instead, they favor a “kick the can down the road” approach of providing emergency bailout funds to temporarily stem insolvency in countries like Greece and Spain). European equities have weakened substantially in response. In both the US and China, manufacturing activity has slowed over the past few months as uncertainty over the health of European consumers and companies mounts.

Back in the financial markets, it seems as if large banks can’t go a few of months without embroiling themselves in a major controversy. This quarter saw two banks — which had emerged largely unscathed from the financial crisis — fall flat on their faces, and one infant institution in Spain cry out for state assistance. At JP Morgan, a trading unit in the chief investment office was given a great deal of discretion and used it to develop an infatuation with a trading model that turned out to be a poor reflection of reality. The result was a loss of a few billion dollars, a number of ruined careers, and the surprising prospect of Jamie Dimon (JP Morgan Chase CEO) apologizing in public. The final cost of the trading losses has not been tallied as yet, but the episode has become exhibit A for the camp advocating strict implementation of the “Volcker rule” which prohibits banks from engaging in proprietary trading. We believe clear and consistent enforcement of the Volcker rule would go a long way towards preventing future financial crises.

Across the pond, Barclays found itself the first major casualty in a developing scandal surrounding the process used to set a key benchmark rate, LIBOR (London Interbank Offered Rate). LIBOR is used to price many financial instruments, including loans and derivatives amounting to hundreds of trillions of dollars. Many adjustable rate mortgages, and most interest rates swaps are based on some form of LIBOR. The rate, however, is determined based on a process developed in the 1980s. Treasury departments at major money-center banks in London submit an estimate of their borrowing rate. The outliers are discarded and an average of the remaining is published. It appears that at least at Barclays, proprietary traders who are supposed to play no part in the process were able to influence the teams providing Barclay’s submissions. Traders whose portfolios were impacted by the rate were able to persuade colleagues into altering Barclays’ submissions in their favor. To add insult to injury, senior managers claimed that regulators had encouraged them to lower the reported rate during the financial crisis so as not to appear weak. The end result: both the chairman and the CEO are on their way out and several other banks are rumored to have been guilty of similar manipulation schemes.

In Spain, Bankia the conglomerate formed by a merger of seven politically important cajas (savings banks) discovered that 2 + 2 = 4 when it comes to bank balance sheets. The large book of real-estate loans it had inherited from its predecessor banks continued to deteriorate and in May Bankia came clean, took a 4 billion Euro loss and asked for a 20 billion Euro capital injection from the Spanish government. Investors fled Spanish government debt once they saw the size of the hole in Bankia’s balance sheet and knew Spanish leaders had no choice but to extend it an open credit line. Seeing Spain’s borrowing costs rise to unsustainable levels, European leaders reached a tentative agreement to create a “banking union” and have European institutions, rather than individual nations serve as a back-stop for failing banks. Predictably, right after this “summit to save Europe” ended, dissenting opinions amongst the 26 Euro member nations made an unwelcome appearance. Markets seem to have gotten the message and the resumed the sell-off.

Meanwhile, the worm continues to turn, oblivious to the effectiveness of monetary or fiscal policy, but perhaps not to the relentless summer heat. An intense heat-wave across the US is being mirrored in the great granaries of Eurasia as well. Both Ukraine and Russia have experienced unusually high temperatures coupled with a long dry spell. The same conditions extend across the great plains of North America. This has begun to impact yield estimates for the corn, wheat and soybean crops, with many fields weakened by the unrelenting heat. Prices have surged, and a continued dry spell could see food prices rise. The sudden price hike in 2008 played a very large role in the global unrest that year.

We continue to advise clients to maintain a defensive allocation and limit exposure to risky assets like long-dated or high-yield bonds, low-quality stocks and commodities.

Here at Washington Square Capital Management, we quietly celebrated a happier anniversary this quarter. April marked three years in our existence as independent investment advisors and financial planners committed to furthering our client’s interests. We would like to thank all our clients and friends for your support and encouragement.

Subir Grewal                                                                           Louis Berger

Before we begin our quarterly market commentary, we wanted to give you a few quick updates.  Louis was recently profiled in the Wall Street Journal online where he discussed the mobile budgeting app we are developing.  The genesis for the idea came from speaking to both clients and non-clients who have expressed a need for on-the-go assistance in tracking their spending habits.  We’ll keep you posted on the app’s progress and let you know when it’s in beta.

Over at the WSQ Capital blog, Subir wrote a blog post examining the fundamental differences between Google and Yahoo in how they approach the internet.  He wrote a second piece where he sites Pandora as a case study for how entrepreneurs can run into trouble if they sell too much equity to outside investors. And to complete the tech trifecta, he wrote a third piece looking at Facebook’s growth prospects just as the hype machine for the company’s IPO grinds into high gear. Meanwhile, Louis wrote a post that provides a primer for investors interested in learning what makes an investment socially responsible.

We look forward to speaking with you over course of the summer.

This has been an eventful quarter in the global markets. We now know that the UK has slipped into a double-dip recession with negative growth in the past two consecutive quarters. The jury is still out on whether this was driven by the relatively austere economic policies adopted by the Tory government and the Bank of England or the general weakness in broader Europe. Looking out east, we see a carefully choreographed political transition in China becoming unexpectedly messy. A very senior official, who was expected to join the nine-member Standing Committee of the Communist Party has been removed from his position in the Politburo and remains under house arrest amidst allegations of wire-tapping and murder. Meanwhile, the housing bubble in China continues to deflate.

Against this background, US stocks continued their upward trajectory. The S&P 500 index (a broad measure of large-cap US stocks) finished the quarter up over 150 points, closing at 1,408.47 – cracking the 1400 point threshold for the first time since 2008. This represented a quarterly gain of 12.59% (which, if annualized, would be 50.36%). These are gaudy returns and we don’t think it’s realistic for investors to expect stocks to continue performing at these levels for the remainder of 2012. So what’s been driving this rally? There has been a confluence of factors:

1. The primary explanation is extraordinary stimulus provided by the Federal Reserve over the past few years in an effort to stabilize the US economy. In addition to its 0% interest rate policy – intended to drive down mortgage rates, boost lending and encourage both investors and savers to flee cash and take on more risk – the Fed has played a direct, directional role in the bond markets via quantitative easing. So far, there have been two major rounds of quantitative easing (QE1 in 2008/09 & QE2 in 2010/11). Both rounds helped prop up equity markets as investors expected the Fed to be ready with its safety net protecting them against catastrophic losses.

In a variation on this theme, the Fed announced “Operation Twist” on Sept 21, 2011. It would sell $400 billion in short-term Treasuries to buy longer-dated bonds, driving down long-term rates. The policy took effect in October and is set to expire in June, 2012. At the time of its announcement, the stock market was mired in a summer slump with investors increasingly jittery about muted economic data and continued problems with the European debt crisis. Once Operation Twist took effect on Oct 1st, the US stock market began its renewed run upward to where we are today.

We recognize that these stimulus policies have been implemented to support the fragile US economy as it slowly emerges from the Great Recession. The catch, however, is that risk-taking investors have come to rely on the Fed’s intervention in the markets. Like clockwork, once these policies are set to expire, equity markets (and other risk assets) have sold off until a new iteration of the policy is announced. This is a dangerous precedent for the Fed to set. A constant cycle of interventionist policies skews market prices and encourages the type of herd-driven speculative behavior that caused the crisis in the first place.

2. In addition to continued Fed stimulus, the stock market has benefited from improving economic data (albeit from very low levels). Unemployment – while still stubbornly high – has continued to drift lower with recent monthly numbers beating expectations. Corporate earnings have beenstrong, especially for large-cap US conglomerates, which have continued to benefit from a weak dollar. Several of these companies have cut costs by reducing head-count and used the savings for share buy-backs and dividend distributions. With interest rates at historic lows, blue chip stocks with dependable dividends are attractive to conservative investors in search of income.

3. The equity rally has also been strengthened by the threat of inflation. The Fed’s policies have brought trillions of dollars of liquidity into the markets over the past few years. This liquidity has weakened the US dollar and driven up commodity prices. The consumer price index (CPI) – which measures changes in the price level of set basket of consumer goods and services purchased by households – has steadily crept upwards over the first three months of 2012. This trend suggests inflation could be closer on the horizon than expected, despite continued high unemployment levels and a stalled housing recovery. Since companies can adapt their strategy and pricing to changed conditions, stocks tend to be a better hedge against inflation than fixed income.

4. As the economy emerges from recession, an overheated economy becomes a very real concern. A majority of the board of governors in the Federal Reserve have stated that they expect interest rates to remain historically low through the end of 2014. However, this is not written in stone. If the economy does rebound and inflation picks up, the Federal Reserve will need to raise interest rates before 2014. Since the Fed can’t lower interest rates any further than where they are now, they will go up at some point. The question, of course is when. Once interest rates do start to rise, stocks will outperform bonds.

As the second quarter is now underway, we have seen a few of these drivers fading (which, not surprisingly, coincided with a selloff in stocks). The Federal Reserve has given no indication that another round of quantitative easing is imminent once Operation Twist expires in June. Corporate earnings continue to be strong, but US economic data, which was strong during the first quarter, has started to flag. If the macro-economy weakens materially, both inflation and the potential for an interest rate hike prior to 2014 become less of a concern and the Fed’s attention will turn back to unemployment. The monetary quiver though, is virtually empty, and there is not much we feel the Fed can do beyond keeping rates low.

So what does this mean for investors?

While we still view equities on the whole as over-valued, there are pockets of value in certain industries, and in individual stocks. We prefer large cap, blue chip stocks with strong balance sheets and dependable dividends. We favor short term, high quality bonds, with a preference for inflation protected or stepped coupon/variable rate securities. We continue to think that there will be an opportunity to buy stocks at an attractive level in the near future.

Louis Berger                                                                   Subir Grewal

Lou was profiled in the Wall Street Journal yesterday where he discussed the mobile budgeting app we are developing.

We did a 30 minute webinar on how socially responsible investing works. We’ve posted it on youtube and you can watch it here.